Fed Chair Discusses Tests of Banks' Health

Fed Chair Bernanke on the Lessons of SCAP "Stress Tests"

In the keynote address on the opening day of the Atlanta Fed's Financial Markets Conference, Federal Reserve Board Chairman Ben Bernanke detailed how the federal banking supervisory agencies conducted the Supervisory Capital Assessment Program (SCAP), also known as stress tests of the nation's 19 largest banking companies.

Capturing a broad snapshot
More than 150 examiners and analysts from the Fed, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corp. spent 10 weeks in an "exhaustive review of loan portfolios, investment securities, trading positions, and off-balance sheet commitments," Bernanke said at the Jekyll Island, Ga., conference. "Typically, supervisory examinations focus on individual business lines or asset classes at a single firm. In this case, we simultaneously reviewed all of the major portfolios and business lines at each of the 19 firms, making unprecedented efforts to achieve methodological consistency across firms, portfolios, and supervisors."

Banks initially submitted estimates of expected losses and revenues, then supervisors evaluated those submissions for omissions, overly optimistic assumptions and other issues, Bernanke said. Detailed conversations with bank managers resulted in numerous corrections and modifications of the 19 banks' reports.

Judgments, models used in tests
Analyzing individual banks and comparing all the firms, examiners then adjusted the loss and revenue estimates. As a third step, the chairman said, the supervisors supplemented their judgmental assessments with objective, model-based estimates for losses and revenues that could be applied consistently across all 19 firms.

"For example, we used statistical models to estimate residential mortgage losses at firms based on loan data submitted by the firms as part of the exercise," Bernanke said.

Recommended capital buffers "appropriately conservative"
A major outcome of SCAP was that 10 of the firms have been required to raise additional capital to withstand loan losses that could result if the economy worsens. Bernanke said the banking authorities view those estimates of necessary capital as "appropriately conservative." He pointed out that the SCAP loss estimates exceed those experienced by banks in past recessions.

Specifically, the SCAP's estimated two-year cumulative losses on total loans under the review's more adverse scenario averaged 9.1 percent across the 19 companies, a higher rate than in any two years dating to 1920, including the worst years of the Great Depression.

One of the goals of SCAP is to increase confidence in the nation's financial system. While initial indications are positive, the ultimate success of that will not be known for some time, Bernanke pointed out. It is already clear, however, that banking supervisors can use lessons learned in SCAP to improve their processes.

"In particular," Bernanke noted, "the supervisory capital assessment has demonstrated the benefits of using cross-firm, cross-portfolio information and the simultaneous review of a number of major firms to develop a more complete and fine-grained view of the health of the banking system."